Which Is Better: Active Or Passive

Few topics generate more heated discussion among investing professional then this question. Active investing takes a hands-on approach and requires a portfolio manager to make decisions about what to buy and sell and when. Passive investing requires little involvement by a portfolio manager and emphasizes a buy and hold approach.  

According to a paper published by the Federal Reserve Bank of Boston, the actively managed mutual funds and ETFs hold the majority of assets invested by Americans. Active funds and ETFs hold 59% of Americans’ wealth. However, index funds are gaining in popularity. Only14% of dollars were invested in index funds in 2005.

The bottom line is which approach is better from a return standpoint? On this question, there is a difference of opinion. Let’s look at some numbers to see if we can come to a conclusion on this question.

Over short periods of time, some actively invested mutual funds and ETFs outperform passive investments. For example, in 2020:

                                                            Outperforming Index

Large growth funds                                       62%

Mid-cap growth funds                                  83%

Small growth funds                                        86%

Source: S&P Dow Jones Indices, LLC  

However, over time, the percentage of actively managed mutual funds and ETFs which manage to do better than their averages dwindles significantly. Look at this table for the last 10 and 20 years:

                                            Outperforming 10 years   Outperforming 20 years

Large growth funds                           17%                                      4%

Mid-cap growth funds                      43%                                        10%

Small growth funds                           43%                                           6%

Source: S&P Dow Jones Indices, LLC 

Please note: there are numerous categories of mutual funds and ETFs. Their results are similar according to S&P Dow Jones Indices, LLC. 

As you can see, the % of actively managed mutual funds in the categories that outperform their index declines over time. This puts the investor and her/his financial advisor in a bind. While a mutual fund or ETF might do well in the short term, what about the longer term?

To add to the investor’s dilemma, the same funds don’t outperform each year. Since 1994, a mutual fund’s performance one year did NOT predict future performance according to two researchers from Yale University. In other words, just because a mutual fund did well one year does not mean it would continue to do well. There is no consistency in performance among actively managed mutual funds.

My conclusion:

In my opinion, and based on the historical data above, actively managed funds tend to trail passive competitors.  Past performance is not an indication of future performance in any investments, but from the historical data, this is especially apparent with active management.  Investing in a diversified mix of passive managed index funds may be a better choice for investors in the long run. 

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